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Easterly explains this failure in terms of a range of perverse incentives on the part both of donors and recipients:

Easterly explains this failure in terms of a range of perverse incentives on the part both of donors and recipients:

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* Donors care about the poor in developing countries. ​ They are therefore to withdraw aid to governments that do not deliver reform, because of the impact of this privation ​on the poor. In this sense, the poor population becomes an '​asset'​ to the recipient government: so long as it maintains a large population in poverty, donors will be forced to provide aid: there is no incentive to get people out of poverty. ​ This is an argument in favour of greater brutality on the part of donors...

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* Donors care about the poor in developing countries. ​ They are therefore ​reluctant ​to withdraw aid to governments that do not deliver reform, because of the impact of this cut in aid on the poor. In this sense, the poor population becomes an '​asset'​ to the recipient government: so long as it maintains a large population in poverty, donors will be forced to provide aid: there is no incentive to get people out of poverty. ​ This is an argument in favour of greater brutality on the part of donors...

* Donor institutions are generally divided into country desks, and the size, budget and prestige of the desk or department depends on the volume of aid it disburses: so the donor'​s decision-maker has a clear incentive to disburse loans under any circumstances,​ and a disincentive to cut loans significantly,​ even in response to non-compliance of recipients.

* Donor institutions are generally divided into country desks, and the size, budget and prestige of the desk or department depends on the volume of aid it disburses: so the donor'​s decision-maker has a clear incentive to disburse loans under any circumstances,​ and a disincentive to cut loans significantly,​ even in response to non-compliance of recipients.

* The connection of loans to policy change encourages recipients to '​zigzag'​ their policy.

* The connection of loans to policy change encourages recipients to '​zigzag'​ their policy.

* Non-performance of old loans is embarrassing to donors, as an admission that their policy reform programmes have failed catastrophically. ​ There is therefore a strong incentive to provide loans to ensure that a poorly performing recipient can continue to meet interest payments on existing loans.

* Non-performance of old loans is embarrassing to donors, as an admission that their policy reform programmes have failed catastrophically. ​ There is therefore a strong incentive to provide loans to ensure that a poorly performing recipient can continue to meet interest payments on existing loans.

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One study claims that 1 per cent in GDP of aid in a good policy environment leads to 0.6 per cent growth in GDP, implying that this failure of structural adjustment loans to achieve an improvement in policy has cost the developing world a great deal of growth.

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Easterly'​s recommendations are simple. ​ Firstly, the amount of aid offered should be conditional primarily on past performance, ​ie proven track record: on key indicators of policy (inflation, black market exchange rate premium) and growth. ​ Secondly, aid should increase as countries become richer and as the numbers in poverty decline. ​ This is absolutely necessary to avoid providing perverse disincentives to growth and poverty reduction.

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One study claims that aid equivalent to 1 per cent in GDP in a good policy environment leads to 0.6 per cent growth in GDP, implying that this failure of structural adjustment loans to achieve any improvement in policy has cost the developing world a great deal of growth.

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Easterly'​s recommendations are simple. ​ Firstly, the amount of aid offered should be conditional primarily on past performance, ​i.e. proven track record: on key indicators of policy (inflation, black market exchange rate premium) and growth. ​ Secondly, aid should increase as countries become richer and as the numbers in poverty decline. ​ This is absolutely necessary to avoid providing perverse disincentives to growth and poverty reduction.

Clearly, the obvious objection to Easterly'​s proposals is that he argues that most aid should be given to those who need it least, and no aid should be given to those in desperate need. His assumption appears to be that the really crucial determinant of growth is policy, not aid, and that growth and poverty reduction can be achieved with good policy and no (or very little) aid. He believes that the empirical evidence bears him out: that aid is only beneficial in a good policy environment,​ so it is better to have good policy and little aid than lots of aid being wasted by bad policy.

Clearly, the obvious objection to Easterly'​s proposals is that he argues that most aid should be given to those who need it least, and no aid should be given to those in desperate need. His assumption appears to be that the really crucial determinant of growth is policy, not aid, and that growth and poverty reduction can be achieved with good policy and no (or very little) aid. He believes that the empirical evidence bears him out: that aid is only beneficial in a good policy environment,​ so it is better to have good policy and little aid than lots of aid being wasted by bad policy.

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Where increasing returns dominate, there is a tendency for increasing returns to create '​traps,'​ that is, virtuous and vicious cycles. ​ In a low-skill economy, the returns to investment in education will be low because of lack of other high-skill workers with whom to cooperate to fully exploit one's skills. ​ The incentive to seek education may therefore be too low to be worth the costs involved, and it will be rational to remain uneducated and poor. It might only be worth investing in education if it is possible to migrate to a high-skill economy to find these matches --- so brain drain tends to exacerbate the problem.

Where increasing returns dominate, there is a tendency for increasing returns to create '​traps,'​ that is, virtuous and vicious cycles. ​ In a low-skill economy, the returns to investment in education will be low because of lack of other high-skill workers with whom to cooperate to fully exploit one's skills. ​ The incentive to seek education may therefore be too low to be worth the costs involved, and it will be rational to remain uneducated and poor. It might only be worth investing in education if it is possible to migrate to a high-skill economy to find these matches --- so brain drain tends to exacerbate the problem.

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Easterly extends this idea of traps to explain variation in income by geography and race purely on the basis of a difference of initial conditions, because under increasing returns variation tends to be self-reinforcing. ​ He proposes a race model in which whites begin as high-skill and blacks low-skill. ​ If there is any segregation in economic enterprise between the races then it may be rational for whites to seek education and blacks to not. Furthermore,​ if there are costs associated with uncovering the true educational level of a particular worker, it may be rational for a white employer to only select whites rather than pay to discover the true educational level, on the basis that the probability that a white his high-skill is high and for a black, low. If white employers are known to use this policy, then it will be rational for whites to pursue education and for blacks not to: even without a legal or geographical divide, the perpetuation of a racial income disparity can be rationally self-reinforcing. ​ This is a broad, powerful and intuitive '​it'​s-not-their-fault'​ defence of low income groups, races, countries and geographical areas.

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Easterly extends this idea of traps to explain variation in income by geography and race purely on the basis of a difference of initial conditions, because under increasing returns variation tends to be self-reinforcing. ​ He proposes a race model in which whites begin as high-skill and blacks low-skill. ​ If there is any segregation in economic enterprise between the races then it may be rational for whites to seek education and blacks to not. Furthermore,​ if there are costs associated with uncovering the true educational level of a particular worker, it may be rational for a white employer to only select whites rather than pay to discover the true educational level, on the basis that the probability that a white is high-skill is high, and for a black, ​it is low. If white employers are known to use this policy, then it will be rational for whites to pursue education and for blacks not to: even without a legal or geographical divide, the perpetuation of a racial income disparity can be rationally self-reinforcing. ​ This is a broad, powerful and intuitive '​it'​s-not-their-fault'​ defence of low income groups, races, countries and geographical areas.

Finally, expectations matter. ​ In deciding whether or not to invest in education, it is not the current state of national skill levels that are important, but expectations of future skill levels when the investment in education comes to maturity. ​ There may therefore be a coordination problem in which many people are willing to invest privately, so long as the others do likewise, though this is generally impossible to negotiate or enforce. ​ But credible promises by some competent agency may be very important.

Finally, expectations matter. ​ In deciding whether or not to invest in education, it is not the current state of national skill levels that are important, but expectations of future skill levels when the investment in education comes to maturity. ​ There may therefore be a coordination problem in which many people are willing to invest privately, so long as the others do likewise, though this is generally impossible to negotiate or enforce. ​ But credible promises by some competent agency may be very important.

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It is worth mentioning the concept of 'mean reversion',​ by which the most predictable outcome in a sample dominated by randomness is that the highest performers will do worse in the next period, and the worst performers will do better.

It is worth mentioning the concept of 'mean reversion',​ by which the most predictable outcome in a sample dominated by randomness is that the highest performers will do worse in the next period, and the worst performers will do better.

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> The principle of mean reversion is universal. All you need to get strong mean reversion is that at least some role for luck and selection of the best outcome of the previous period. Mean reversion explains why the Rookie of the Year in the American League has a worse second year (the so-called sophomore jinx --- the Rookie of the Year moves back toward the average after an exceptional first year), why the NFL Super Bowl winner seems to fall apart the next year (the team doesn'​t really fall apart; it just falls back toward the mean), why second novels are disappointing (we pay attention to the second novel only when the first was exceptional),​ why movie sequels are usually not as good as the original (a sequel is made only after an extremely successful movie, an extreme success is unlikely to recur), and why a stock market prognosticator falls out of favour right after a streak of accurate predictions (she had a lucky streak that got our attention and then reverted to average). ---p205

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> The principle of mean reversion is universal. All you need to get strong mean reversion is at least some role for luck and selection of the best outcome of the previous period. Mean reversion explains why the Rookie of the Year in the American League has a worse second year (the so-called sophomore jinx --- the Rookie of the Year moves back toward the average after an exceptional first year), why the NFL Super Bowl winner seems to fall apart the next year (the team doesn'​t really fall apart; it just falls back toward the mean), why second novels are disappointing (we pay attention to the second novel only when the first was exceptional),​ why movie sequels are usually not as good as the original (a sequel is made only after an extremely successful movie, an extreme success is unlikely to recur), and why a stock market prognosticator falls out of favour right after a streak of accurate predictions (she had a lucky streak that got our attention and then reverted to average). ---p205

//​[[wp>​In Search of Excellence]]//​ provides a good example --- a survey of thirty-six exceptional companies, around two thirds of which performed below average over the course of the next period.

//​[[wp>​In Search of Excellence]]//​ provides a good example --- a survey of thirty-six exceptional companies, around two thirds of which performed below average over the course of the next period.

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This seems to be one of the weaker arguments, in particular because a high budget deficit is such a natural consequence of negative external shocks (eg terms of trade shocks) that Easterly has already identified as a growth killer. ​ He spends some time on a single case study --- Mexico --- which seems to start from a sound economic position, adds budget deficits, and ends in collapse, but whether that story generalises is a little more unclear.

This seems to be one of the weaker arguments, in particular because a high budget deficit is such a natural consequence of negative external shocks (eg terms of trade shocks) that Easterly has already identified as a growth killer. ​ He spends some time on a single case study --- Mexico --- which seems to start from a sound economic position, adds budget deficits, and ends in collapse, but whether that story generalises is a little more unclear.

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* Killing banks: in particular, through usury laws which place an upper limit on nominal interest rates, thus forcing banks to offer negative real interest rates under conditions of moderate-to-high inflation. ​ Savings are withdrawn and sent abroad or invested in real estate, and banks are left with no working capital to lend. Little is said on the relation between this issue and inflation --- clearly it only exists in countries with substantial inflation problems. ​ Also, a real interest rate of between ​zero and --20 are viewed as a '​mild'​ problem, still likely to accompany positive (though reduced) growth.

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* Killing banks: in particular, through usury laws which place an upper limit on nominal interest rates, thus forcing banks to offer negative real interest rates under conditions of moderate-to-high inflation. ​ Savings are withdrawn and sent abroad or invested in real estate, and banks are left with no working capital to lend. Little is said on the relation between this issue and inflation --- clearly it only exists in countries with substantial inflation problems. ​ Also, a real interest rate of between --20 and zero per cent is viewed as a '​mild'​ problem, still likely to accompany positive (though reduced) growth.

* Closing the Economy: this is where we begin to stagger over really difficult ground. ​ There'​s a quick stab at the evils of import substitution,​ listed as

* Closing the Economy: this is where we begin to stagger over really difficult ground. ​ There'​s a quick stab at the evils of import substitution,​ listed as

* It's based on the mistaken prediction that commodity prices would trend downwards. ​ Easterly mentions the difficulty of taking into account gradually improving quality of manufactured goods --- without mentioning that surely this is the main motivation to diversify towards manufactures:​ there are higher productivity improvements over time than can be expected in commodity production, so it's the '​right'​ long-term path to be on (irrespective of current '​comparative advantage'​). ​ The prediction that commodity prices would trend downward seems to me to be a sound application of the precautionary principle --- nobody knew at the time, and it would have been extremely dangerous for the poor world had they declined rapidly.

* It's based on the mistaken prediction that commodity prices would trend downwards. ​ Easterly mentions the difficulty of taking into account gradually improving quality of manufactured goods --- without mentioning that surely this is the main motivation to diversify towards manufactures:​ there are higher productivity improvements over time than can be expected in commodity production, so it's the '​right'​ long-term path to be on (irrespective of current '​comparative advantage'​). ​ The prediction that commodity prices would trend downward seems to me to be a sound application of the precautionary principle --- nobody knew at the time, and it would have been extremely dangerous for the poor world had they declined rapidly.